“Muni Bonds”, short for municipal bonds are an underrated, hidden secret right now for many reasons. With market uncertainty, it can be advantageous to invest in a bond versus a stock because bonds are completely different investments than stocks and have the advantage of not being as susceptible to market movements. Whereas a stock is a “piece” of the company, a bond is simply a promissory note that the company or municipality will pay you back your money, plus interest.
Bonds are attractive right now because of the rise in interest rates. This time last year they were paying 1-4%. Now they are paying 5-9%. In fact, this rise in interest rates is part of the reason that the stock market is struggling to gain traction. Investors are seeing that they can make 5-9% return with a bond that has less implied risk than a stock. Typically individual bonds do not go down in value as stocks do, though a bond fund or ETF can be more susceptible to market movements, as we saw in 2022 where stock and bond funds both tumbled together due to the Federal Reserve’s rapid increase in interest rates.
There are all types of bonds including government bonds, corporate bonds, high-yield bonds know as “junk bonds”, and municipal bonds. Junk bonds are not necessarily junky, they are simply called that because they are offered by less established companies. Because of the extra risk that investors take on to buy a “junk bond” there is a risk premium applied. In other words, junk bonds pay more to investors because they can be more risky.
I like high-yield “junk” bonds because they pay higher dividends, but I prefer municipal bonds even more because not only can they also pay high dividends, but also because those dividends are federally tax free and depending on which state you live in, they can be state income tax free as well! A muni bond is offered by a municipality such as a city or state. The funds are raised typically to build a bridge, pave a road, or renovate a state park or building, etc. The tax code incentivizes investors to invest in these projects because they are for the common good. The incentive is that you don’t have to pay tax on the dividends! This can be a huge tax benefit, especially for high earners in high tax brackets.
As an example, let’s assume you’re in a 32% tax bracket, plus 5% VA state income tax (approx.) and have the option to invest in both a junk bond or a muni bond:
Junk bond paying 9% interest = 5.67% after-tax yield
Muni bond paying 8% interest = 8% after-tax yield because it’s tax-free!
This of course is assuming you’re investing in a taxable account. If you’re investing in a retirement account, then your taxes are deferred and this doesn’t apply. Even better, if you’re investing in a Roth IRA, those are after-tax dollars in a tax-free growth account so the junk bond would be a better play in this scenario.
Muni bonds can be an attractive investment because of their tax-free qualities and are worth considering for your portfolio. This is not advice specific to your situation. It is always a good idea to talk about this with your tax or investment advisor before making any decisions.
When Daniel is not giving financial advice or managing investments, he enjoys renovating properties, real estate investing, drinking coffee, hanging out with friends, spending weekend trips in his camper van, and exploring the outdoors on a hiking or biking trail in his hometown of Roanoke, VA and beyond.